I recently attended (actually spoke at) a training session for new hires at a major accounting firm. The speaker immediately before me was a well known partner in a prominent venture fund. In response to a question from the audience, he asserted that, although not perfectly, the basic structure of convertible preferred stock universally used in the venture industry aligns the interests of investor and entrepreneurs (management).

While I am confident that most, perhaps all venture investors, believe this to be the case, I do not think the sentiment is shared by most, or even a majority of, entrepreneurs. As I have noted in prior posts, the divergence of interests can most clearly be seen in the case of preferred stock with a preference and participation. These terms set up a situation in which the investor can make a return (not a brilliant return – but perhaps a single or maybe even a double) in an exit in which the founders and management make very little. Investors may be willing, or even eager, to sell at valuations that are real disappointments to the founders and management. Another term that can misalign interests is dividends. In a sale, investors typically get their investment plus any accrued dividends before the holders of common stock get anything.

I am not sure that the misalignment can ever be fixed. Perhaps a better way to say it is that I am not sure that alignment can ever be perfect. Having said that, the prevalence of preferred stocks with preference and participation is setting up a situation in which there will be a lot of friction between founders and management on the one hand and investors on the other hand – especially in a weak market for exits where valuations are likely to be low. We are likely to see this play out starting in about one year.